This is a new feature in Bearnobull. From time to time, I will write on situations which I consider compelling, either buy or sell, based on valuations. These will always be securities that I personally buy or sell, the write-ups being essentially my own reasoning behind the moves, for my own benefit but which I dare to share. Anybody who acts on these would be well advised to do his/her own research and to read the disclaimer to this blog.
Note: Many additional supporting charts for this analysis are available in Bearnobull’s Library (with the usual restriction).
BUYING CANADIAN BANKS
Canadian banks are among the best run banks in the world, operating in an oligopolistic environment and supervised and regulated by a conservative Federal Government agency. Here’s the rundown on the sector’s current valuation:
- The absolute median P/E on trailing EPS is 10.2x, at the low end of a 20-year range of 10-15 excluding recessions (next two charts courtesy of CPMS/Morningstar)
- Net operating margins are near their 2011 all-time high. Margins are FIVE times higher than in 1994 and 26% higher than their 2005 previous peak.
- Median Price to Book Value at 1.3x is also a the low end of its 20-year range of 1.17x (2009 trough) and 2.7x (2006). Since 2010, P/BV has fluctuated between 1.2x and 2.0x.
- Median ROE, the main driver for P/BV, is currently 13.6%, in the middle of its 20-year range of 9%-18%. On a cap-weighted basis, ROE is 16.2% as the two largest banks have sustained high ROEs: CIBC: 19.9% and Royal: 18.7%, both banks being heavily sensitive to Canada as opposed to the other 3 largest banks (BMO, TD and BNS) which have more meaningful foreign activities.
- The average dividend yield is currently 4.6%, weighted down by TD’s 3.9%. RY’s is 4.4% and the other 4 banks are at 4.8%. Except for the 2008-09 financial crisis, this is the highest dividend yield on Canadian banks in 20 years. Since 2010, the range has been 3.7-4.7%.
- Canadian banks never cut dividends (only National Bank cut it in 1983 and 1992-93). Banks generally hike their dividends every second quarter.
- EPS are growing nicely this year. Even TD and BNS, facing tougher conditions in their respective markets, have increased their earnings.
In all, this is a great opportunity to buy some of the best banks in the world at bargain prices. Canadian banks are down 14% (weighted) from their April 2015 peak and are down 11% YoY. Canadian bank stocks have fluctuated in a pretty constant range of –10% and +25% price swings on a YoY basis since 1987.
Why are they so cheap?
U.S. hedge funds have this recurring tendency to see Armageddon hitting Canadian banks every once in a while. It just does not happen because Canadian banks are much better run, much better capitalized and much better supervised than U.S. banks. One trader wrote last March:
It is a true statement that Canadian banks have never blown up. Ever. Don’t you think that’s weird? Every other developed country in the world has had a banking
crisis at one time or another. Not Canada. Never happened. So you can look at this one of two ways:
1. Past performance is no indicator of future results.
2. They are due.
How about a third way? Canadian banks are very conservatively run. And resilient as BMO Capital Markets put it after the banks released their Q3 results in August::
“resilient /rɪˈzɪlɪənt/ adj. able to withstand or recover quickly from difficult conditions.” Oxford English Dictionary.
That’s the best way to describe the Q3/15 results of the Canadian banks. The results were generally better than expectations and the industry’s operating EPS were up 5% year over year, and the industry delivered an operating ROE of 16.2%, down from 17.6% last year; ROA was 84 bps, down from 89 bps last year. The “Big 6” CET1 ratio was a solid 10.2% up from 9.8% last year but flat sequentially as good internal capital generation was offset by growth and the FX impact of a depreciating Canadian dollar. Three key highlights from this quarter (for individual bank summaries refer to Appendix B) are:
- Canadian Resiliency. The Canadian Banking segment, which accounted for 49% of the industry’s bottom line and where the “Big 6” enjoy an unfair advantage, had 5% higher earnings from last year on resilient volume growth of ~5%, positive (albeit marginally) operating leverage, and sequentially better risk-adjusted margins (stable to improving spreads and credit costs).
- Revenue Resiliency. Notwithstanding the continued headwinds of a low rate environment (~50% of industry revenue is spread based), the industry was able to deliver a 6% year-over-year top-line growth, a testament to the diversified business model of the banks (across geographies and revenue sources).
- Credit Resiliency. It was another good credit quarter with industry PCL ratio of 29 bps, which compares with a 20-year average of 40 bps. Given the precipitous drop in oil prices, all the banks provided updates on their direct and indirect oil and gas lending exposure, with CM going as far as quantifying potential stress losses from a prolonged period of low oil prices. Higher credit costs are inevitable but not imminent.
Buying Canadian banks here provide a cheap way to participate in potential trend changes in the next year with minimal capital risk and dividend income in the 4.5% range. All Canadian bank stocks would benefit if oil prices were to firm up and/or if Canadian housing remains solid and/or if the Canadian recession risk subsides. Also, TD and BMO allow participation in the U.S. banking business. Finally, BNS is a conservative way to invest in a potential turn in emerging markets through its exposure in Mexico and a few other Latin American countries.
Oil and Gas Risk
All the banks commented on their direct and indirect lending exposure to declining oil prices. All noted that continued low prices may lead to additional but manageable loan losses. (BMO)
BMO summarized each bank direct and indirect exposure to oil and gas:
The BMO analyst went on to stress test the EPS assuming $30 oil for 3 years finding that the range of losses would be 3-4% of his 2016 estimates.
Housing Risk
Shorts on Canadian bank stocks are almost exclusively American investors. Their memories of the U.S. housing debacle are still alive and are easily transposed to the Canadian scene when they see Canadian house prices and consumer debt. This next chart has probably triggered a lot of shorting action, even though both “debt” and “income” are defined in much different ways in the U.S. and Canada.
Without going into all the details, Gluskin Sheff’s David Rosenberg did the calculations on an apples-to-apples basis which makes the Canadian ratios still elevated but much less dramatic.
I am not suggesting that banks are not assuming much mortgage risk, but the facts are that there are a number of structural issues that differentiate the Canadian and U.S. housing markets such as, among many others, the facts that 55% of residential loans (45% of total loans) are fully insured, Canada has more prudent underwriting standards with a single regulator and banks require low Loan-to-Values ratios (homeowners’ equity as a share of real estate is 70%). Also, keep in mind that Canadian banks are not involved in the subprime market.
These BMO Capital charts illustrate how Canadian banks have improved their loan management, reduced their risk exposure while improving their returns over time:
The main risks for Canadian banks are a full fledge recession and/or a rapid rise in interest rates. While Canada is technically in recession because of the impact of oil on Western Canadian provinces, the rest of the country is doing better and will keep Canada from having a traditional recession. The silver lining is that Canadian interest rates are not about to rise meaningfully. Lastly, there is a political risk over the shorter term if the Conservative Party is defeated in the October elections. Current polls indicate a 3-way split in Parliament seats with more than a month to go.
For investors, the combination of lower oil prices and relatively elevated house prices and consumer debt have created enough anxiety so that Canadian banks valuations have become very compelling. Over the last 59 years, Canadian bank stocks have had only 14 negative years from a total return viewpoint.
It is pretty rare that one can buy high quality companies at bargain basement valuations with 4.5% fairly secure dividend yields.